There is a difference between payment of a defined lump sum by
means of a series of recurrent payments and payments that go on in
perpetuity. The former may represent instalments of a capital sum,
the latter will not.
The case of Commissioners of Inland Revenue v Mallaby-Deeley
and Another [1938] 23TC153 concerned the arrangements used to
finance a literary work.
In November, 1926, Sir Harry Mallaby-Deeley, Bart undertook
to pay a sum of money in five equal amounts to finance the
completion of a literary work ('The Complete Peerage, or History of
the House of Lords and all its Members'). On 10th March 1930,
Mallaby-Deeley entered into a deed of covenant. The deed was
exchanged for the original undertaking, but the deed contained no
reference to the original undertaking. Under the deed
Mallaby-Deeley was to pay, in each of seven years ending 31st March
1936, sums, which after deduction of income tax, ranged from
£5,600 in the first year to £700 in the last year. In
aggregate the sums payable equalled the balance remaining due at
1st April 1929, under the original undertaking.
On appeal Mallaby-Deeley claimed that the respective amounts
payable under the deed of 10th March 1930, with an appropriate
addition for income tax, were proper deductions in computing his
total income for surtax purposes.
The Special Commissioners decided:
In the Court of Appeal the Master of the Rolls, Sir Wilfrid Greene, explained that to distinguish between payments of an income and of a capital character it is necessary to determine the precise nature of the transaction. If parties agree that the one shall pay to the other a capital sum, the nature of that sum does not change if it is paid in instalments. Sir Wilfrid Greene summarised the position in the middle of page 166:
The distinction which is to be drawn for the purposes of the Income Tax Acts between payments of an income character and payments of a capital nature is sometimes a very fine and rather artificial one. It may depend upon - in fact it does depend upon - the precise character of the transaction. To take a simple case, if the true bargain is that a capital sum shall be paid, the fact that the method of payment which is adopted in the document is a payment by instalments will not have the effect of giving to those instalments the character of income. Their nature is finally determined by the circumstance that the obligation is to pay a capital sum, and instalments are merely a method of effecting that payment. On the other hand, to take another simple case, where there is no undertaking to pay a capital sum and no capital obligation in existence, and all that exists is an undertaking to pay annual sums, those may, in the absence of other considerations, be annual payments of an income nature for the purposes of the Income Tax Acts. The operation of that distinction in individual cases may present some appearance of unreality. Nevertheless, it is a distinction which is now well-founded…
Applying this analysis to the facts, Sir Wilfrid said that the
true construction of the documentation before the Commissioners
showed there was a covenant to pay the balance of £28,000 by
annual payments of £5,600. In other words, a covenant to pay a
capital sum by instalments and not a covenant to make annual
payments in the nature of income. The instalments were simply the
means of liquidating a capital obligation and so were capital.
The case of Commissioners of Inland Revenue v 36/49 Holdings
Ltd (In Liquidation) [1943] 25TC173 concerned periodical payments
for shares the quantum of which was linked to the sales of the
company concerned. The issue being whether the periodical payments
were capital or revenue.
36/49 Holdings Ltd was an investment company that was
incorporated on 27th January 1937 to acquire the whole of the
issued share capital of a trading company, Rudge-Whitworth Ltd (R
Ltd). The consideration being the whole of 36/49 Holdings
Ltd’s authorised share capital.
By an agreement of 3rd March 1937 with two other companies,
the Gramophone Co Ltd (G Ltd) and E.M.I. Ltd, 36/49 Holdings Ltd
sold their shares in R Ltd to G Ltd. The consideration included the
sums of:
sold by R Ltd, G Ltd, E.M.I. Ltd, or any subsidiary company of
those companies.
Payments under the sales linked clauses were to be accounted
for and made quarterly, and were to continue 'at all times
thereafter'. G Ltd had the right under the agreement to commute
future payments for a sum of £50,000 at any time between
December 1938 and January 1949.
36/49 Holdings Ltd estimated the total amount receivable as
consideration at £150,000 and the difference of £137,950
between this sum and the assets as previously shown in the balance
sheet was carried to reserve and the greater part of it capitalised
by the creation of unsecured loan stock which was distributed among
36/49 Holdings Ltd's shareholders.
36/49 Holdings Ltd treated payments under the sales linked
clauses as capital. The total sum received by November 1939
amounted to £142,048. In July 1940, 36/49 Holdings Ltd went
into voluntary liquidation.
Directions were made for a number of years such that 36/49
Holdings Ltd’s income was apportioned among its members.
36/49 Holdings Ltd contended that the directions should be
discharged, but that, if they were confirmed, in computing 36/49
Holdings Ltd's income for the purposes of apportionment, sums
received under the sales linked clause should be excluded as
capital.
The Special Commissioners confirmed the directions but
discharged the apportionments on the grounds that the payments
under the sales linked clause were receipts of capital.
In the Court of Appeal the Master of the Rolls, Lord Greene,
explained why the receipts under the sales linked clause were
income. Lord Greene said that the first thing to do is to look at
the contract itself and obtain from it such assistance as it
affords. The contract seemed to him on the face of it to mean what
it says. Lord Greene said that the contract was for a sale of
assets for a purchase price with two components:
By itself a periodical nature does not conclude the question.
There are many cases in which periodical payments have nevertheless
been held to be in the nature of capital payments. Where the
purchase consideration built up of two (or more) elements, the fact
that some of the elements are of a capital nature does not the
least determine that the periodical payments must also of a capital
nature.
Lord Greene then considered in detail the terms of the sales
linked clause. He said that the clause had some very remarkable
features. First of all it was helpful to observe that the amounts
to be paid under the clause are in effect an element of the total
consideration attributable to the items of property of R Ltd upon
which no value had been set elsewhere in the agreement. The items
in question being goodwill, patterns, drawings, trademarks, patents
and designs. It seemed to Lord Greene that the sum of one shilling
per bicycle or £1 per motor bicycle was in the nature of a
consideration for those elements in the assets of the company.
Lord Greene then observed that unless the right to commute
was exercised, the payments go on in perpetuity. He found it very
difficult to classify as 'capital' a perpetual payment. In the
lower half of page 183 Lord Greene says it is difficult to see such
annual payments as instalments of a capital sum:
The length of time during which a payment is to endure may be a very important factor in determining its character. It is obviously much easier to treat a payment which is only going to extend over two years as really a payment of purchase price by instalments, than it is to treat a payment which it is contemplated may continue in perpetuity. That characteristic of these particular payments appears to me to be one of substantial importance.
…The next point to observe about it is that the sums payable under this sub-paragraph are not tied in any way or related in any way to any special sum whatsoever. Indeed, regarding the payment as a payment which may continue in perpetuity, it seems impossible to say that it is to be regarded as payment by instalments of a capital sum. What is the capital sum? Not merely, therefore, is there no reference to or dependence upon any capital sum, but the very nature of the payments appears to exclude the idea that any connection with any such capital sum was ever present to the mind of anybody.
Lord Greene thought it important that the disputed payments were related to turnover and that the right to commute was unilateral. The power of commutation did not relate the periodical sums payable on turnover to a capital sum. On the contrary, the matter was expressed in such a way that the capital sum is to be paid for the purpose of terminating a payment which is in its essence periodical and which unless terminated will go on forever. He summarised the position in the upper half of page 184:
It seems to me that all those factors, when taken together, stamp upon these payments indubitably an income character. I can find no element present which would justify me in attributing to them a capital character. Neither from the point of view of contract, the actual contract that the parties have made, nor from the point of view of any business or accountancy consideration, can I find any justification for saying that these sums are of a capital nature.
The payments under the sales linked clause were therefore income and not capital.
